Delaware’s Shrinking Half-Life

Mark J. Roe - Harvard Law School

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Corporate law academics have long sought to fully understand the process of state corporate lawmaking. For decades the debate was premised upon strong, ongoing state-to-state competition, with sharp disagreement on the directionality of that competition. In this decade, however, a powerful revisionist perspective has emerged that states do not compete, leaving Delaware alone with a monopoly in the interstate charter market. Marcel Kahan and Ehud Kamar showed in their influential The Myth of State Competition in Corporate Law in the Stanford Law Review that no state other than Delaware actively seeks chartering revenues and concluded, as the title indicates, that states just do not compete. Others offered similar views, sometimes with differing analytics.

Now that we know that ongoing, day-to-day franchise tax competition is just not happening, we need to reframe the inquiry to examine the constraints that Delaware does face. If no state is immediately poised to take franchise revenues away from Delaware, does Delaware have unlimited discretion? If it does not, where do those limits come from?

Delaware does face constraints, and they do not seem small. First, Delaware’s chartering business interacts with the dynamism of the real economy in ways that make it hard for Delaware to rest on its franchise tax laurels. Even if no other state actively competes for chartering revenue, Delaware itself must vie to sell new charters because it needs to draw reincorporations from other states. Conceptually, this is clear. The question is its degree. When, decades ago, business turnover in the economy was slower than it is today, this competitive channel was not particularly important. Firms, or most of them, stayed organized from year-to-year about the way they had been. Once Delaware captured a firm’s franchise revenue in one year, that firm tended to be a reliable Delaware taxpayer in future years. But as corporate restructurings, spin-offs, mergers, and turnover have accelerated, keeping this channel flowing in to Delaware has become increasingly important for the state. Indeed, that acceleration has squeezed the half-life of its tax base down from a quarter century to a decade. That is, half of Delaware’s tax base in recent years comes from firms that got their Delaware charter in the prior decade; twenty years ago the tax base was more stable, with half of it coming from firms that got their Delaware charters in the prior quarter of a century. Delaware must run ever faster just to stay in place.

Second, another state, North Dakota, actively entered the market for corporate charters, drawing intense attention from Delaware and increasing attention from corporate dealmakers and corporate law academic analyses. Activist investors sought a corporate law attuned to their agenda and sought (unsuccessfully) first that Vermont and then (successfully) that North Dakota accept their agenda. Although that state has captured few reincorporations yet—and, hence, little in franchise fees—the North Dakota development potentially constrains Delaware, even if that constraint is only a loose one now. The North Dakota scenario highlights how severe state competition could break out:  not from an aggressive, innovative legislature (a mode usually thought to be unlikely and, hence, one of the reasons we’ve seen state competition as weak), but from disgruntled Delaware corporate players who instigate another state to enter the fray.

And, third, Washington, D.C. has always been a corporate governance player. In the scandals of the early part of this decade and the economic turmoil of the latter part, its role in potentially displacing and often enough affecting state lawmaking has become increasingly vivid. The early part of this decade saw Congress pass the Sarbanes-Oxley Act, a major corporate law statute. The end of the decade sees the Securities and Exchange Commission considering a major restructuring of corporate law that would give disgruntled shareholders access to their company’s proxy solicitation apparatus in a way that could shift corporate law authority in the firm.

Each of these three channels deserves further attention. For the first channel—the intensity of corporate turnover in the real economy, impelling Delaware to have to scramble to sell new charters just to stay even—data I obtained from the Delaware Secretary of State’s office show flow and turnover of Delaware’s tax base to be substantial in the past decade. Although ongoing state-to-state competition for chartering revenues is somnolent, as has been shown, competition in American business—in the real economy—is not. Preexisting Delaware-chartered firms merge, restructure, or close, thereby eliminating in each case one source of Delaware’s franchise fees. To keep up, Delaware must draw new firms into the state. The raw chartering numbers show that about 10% of the chartered firms at the beginning of each year are gone by the end of the year. And, typically, 10% of the firms at the end of the year are new firms that Delaware has drawn in. The dynamism of the real economy interacts with the structure of the chartering market to create a major arena where Delaware must continually vie for charters.

The data reveal another trend: just as we corporate law academics were coming to the conclusion that state chartering competition wasn’t happening, this pressure on Delaware to maintain flow has increased. Briefly put: only a couple of decades ago, the half-life of Delaware’s tax base was on the order of a quarter century. That posed a real consideration for Delaware, but was long enough not to be of immediate concern to the typical career state official, legislator, or local lawyer. This pressure has intensified, however—due to increasing pressures coming from the real economy interacting—to reduce the half-life of Delaware’s tax base down to a decade.

Delaware must continually provide enough value to new firms arising in other states (and to their controlling decisionmakers) to induce them to reincorporate into Delaware. The current focus on whether state lawmakers are sufficiently dynamic and competitive is surely warranted, but potentially overemphasized. Even if states are insufficiently dynamic and competitive, American business is dynamic. Firms arise, prosper, and merge. Others arise, fail, and disappear. For Delaware’s importance to persist over the decades, it must convince new firms to reincorporate away from their home states.

Second, Delaware faces other constraints. We can call those constraints competitive ones, if we expand our concept beyond ongoing competition for chartering revenue. Or we might just think of them as pressures and constraints preventing Delaware from being a fully free agent in its corporate decisionmaking, due to potential competition. Delaware must be wary of making a major mistake, one that would not just induce the inflow to dry up, but that could induce a new, previously inactive state to enter the market, conceivably in a way that could irreversibly erode Delaware’s existing base of charters if corporate America becomes unhappy with Delaware (or one that arrests the flow of firms that reincorporate into Delaware). Even states not actively seeking charters today can potentially compete in this limited sense with Delaware. Such a concept has a parallel in the industrial organization literature on contestable markets: a single producer can putatively dominate a market, but could lose its market share overnight. Hence, it acts like a competitor on some matters, or knows it must provide an overall package that is attractive to its primary customers. It has slack, but that slack is not unlimited, because its market, like Delaware’s, is contestable.

In this dimension, the focus on slow state bureaucracies and uninterested state legislatures is justified but easy to overemphasize. Thus, the second major constraint on Delaware is that the relevant actors who could undermine Delaware’s lead would be the interests already in Delaware. If they became unhappy with Delaware, it’s corporate players who would push another state to actively seek corporate charters. Corporate interests are not passive consumers, forced by the absence of another state purveying its own corporate law to accept whatever Delaware decides to offer. They can lobby another state’s lawmakers, ask for new law, offer that state the tax benefits of the law, and do the initial legal work; they are the ones who would motivate and press Delaware to change. And, as if to demonstrate this possibility, shareholder activists, unhappy with Delaware law, went shopping for a friendly state in the past couple of years and found one—North Dakota—to put competitive pressure on Delaware.

Delaware, despite not facing the intense Economics 101 competition of many other producers of corporate law, faces a contestable market, and that contestability limits the breadth of Delaware’s discretion. Its position is contestable horizontally, subject to several powerful interstate pressures. And it’s also contestable vertically, subject to pressures from Washington, the third major channel confining Delaware’s range of discretion. For example, Delaware legislation passed in March 2009 could seriously change core parts of corporate law dealing with election contests and access to the company’s proxy statement. That legislation is best understood as motivated by one or the other, or both, of these horizontal and vertical dimensions to competition.

That Delaware competes in some sense seems indisputable: its principal lawmakers are active, involved, and energetic. Indeed, as one inside commentator tells us, even if Delaware has won some race or another, “no one in Delaware is willing to play hare while some other state tortoise gains ground.” Delaware players worry. They don’t face day-to-day, head-to-head competition with other states for corporate chartering revenue, as we now know. But they are not free agents. Their actions are constrained.dingbat

Acknowledgments:

Copyright © 2010 Stanford Law Review.

Mark J. Roe is the David Berg Professor of Law at Harvard Law School.

This Legal Workshop Editorial is based on the following Article: Mark J. Roe, Delaware’s Shrinking Half-Life, 62 STAN. L. REV. 125 (2009).


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